Good stocks must have a good story
My stock selection metrics
The best mousetrap + market position + validated products
When I was a kid, my dad would tell me stories about his time spent working as a stock chartist at the brokerage firm my grandfather formed back in 1929. It’s no secret that all kids growing up have an innate fascination with their dad’s life experiences and for me, my favorite stories were about stocks.
Later, in an effort to stay awake during a boring summer job, I asked the president of the company to allow me to read his Wall Street Journal during my lunch hours. I started out studying the newspaper every day, front-page to back, in an effort to escape into a daydream off the job site. As fate would have it, this cure for boredom developed into a thirst for actionable financial knowledge.
Soon afterward, I made my first stock purchase, and my return on investment as a first-time investor in the stock market turned out to be a lot of money. I was firmly hooked.
Over these many years, I’ve learned a thing or two about investment research that I’m pleased to share with you today.
The most important point involves a universal condition that must be present before any stock goes up or down. Just as my father’s stock storytelling attracted me to invest, a publicly traded company must have a potent story behind its business to attract me to invest.
Stock prices frequently move in tandem—the power of the broad market is strong—but certain individual stocks can diverge dramatically from the overall stock market. Unlike most corporations, a few specialized companies—because of the nature and type of operations they’re involved in—are capable of growing sales and profits regardless of the overall economy.
As an investor in the stock market, your job is to find the company that has an innovative catalyst (a product or service) that fits into a powerful business/consumer trend and whose stock price is not yet tethered to the stock market as a whole.
My investment strategy is to use a thematic approach, which allows me to invest in stocks much earlier than institutional investors, average investors and traders. I buy a stock based on the attractiveness of the prospective growth in the business model.
The criteria I use for investment selection are similar to those used by most investors: growth and value. The difference is that my interest in a company is sparked much earlier than my counterparts in research services or investment funds.
I look for the better mousetrap, a viable product and end-user demand before the results appear in the company's financial reports. Essentially, I want to find the “most wanted” stock before the “most wanted” posters go up (and everybody knows the story).
I use the same research strategy that successful venture capital funds use for finding stocks. Let me demonstrate with a recent example.
On July 6, I recommended AuthenTec Inc (AUTH) to subscribers of Cabot Small-Cap Confidential. At the time of my recommendation, the stock price was 4.30 a share. Three weeks later, Apple agreed to acquire the company for approximately $350 million or 8.00 a share.
At this point, you’re thinking, “Wow, great timing!” Indeed, I had no idea the payoff would come so quickly. But I wasn’t surprised, because when I decided to invest in AuthenTec, my actions were fundamentally aligned with the reinvigorated energy of the company’s products and addressable markets.
My intense research indicated that eventually buyers would line up to buy the AuthenTec stock. The stock had traded in the 3.00 range for months, and I focused on thematic metrics that I use to identify sales growth approaching high gear: building a better mousetrap (application/ease of use), trends affecting product demand and product validation.
Here’s my research in a nutshell.
AuthenTec's lead product is its fingerprint sensor. It’s the only available smart sensor marketed that can read the five layers of skin below the surface of the skin, where the unique ridge-and-valley patterns of the fingerprint originate. With just the swipe of a finger across the fingerprint sensor, simultaneous user authentication occurs based an individual’s own unique fingerprint pattern. In this manner, an electronic device, such as a laptop or mobile phone can be securely accessed with the ease of touch.
One of the most important trends in the use of smart sensors is in the area of secure communication for mobile commerce, using near field communication (NFC) radio to make mobile wallet payment transactions. With an AuthenTec sensor integrated into the smartphone, the transaction is facilitated with sensor and one easy swipe touch.
As an alternative to PINs and passwords for transaction security, smart sensors provide stronger fingerprint security and encryption. A one-time password can be created when you swipe your finger on the flat-surfaced sensor and credit card information is released upon verification of a fingerprint match.
So AuthenTec's products offer a better mousetrap than comparable products offered by their competition.
Next, I verify that marketplace trends will support demand for each product.
Today, mobile phones are very much a part of our daily lives. We now are more inclined than ever to use mobile phones to access content and services anywhere. And now mobile phones are extending into mobile commerce.
Everything that’s in your wallet, such as credit cards and identification, can now go on your mobile phone, so securing these devices from theft or loss becomes vitally important.
Phones have been used as mobile wallets in Japan for seven or eight years. Pent-up demand for NFC technology and secure mobile payments is currently building in the U.S. and worldwide. Clearly, the marketplace needs a sensor-like solution to protect mobile payments and disseminate digital content for subscriber viewing on their portable devices.
Then there’s the law of large numbers.
The law of large numbers simply means that the products target vast end-markets. As an investor, I want my companies to have the greatest chance of succeeding selling their products and services and making the most money at doing so.
According, to Cisco, the number of mobile devices by the end of 2012 will exceed the number of people on earth. iSuppi research projects that by 2015, 545 million NFC-enabled mobile phones will ship compared to tens of millions in 2011.
Countries like China and India have unique ID cards with biometric details including fingerprints. The impact on commerce will be significant for AuthenTec as these IDs tie into mobile terminals for government and merchant services.
With significant demand conditions in place for AuthenTec’s offerings and a confirmation of the market size, I next looked to validate product leadership.
In most cases, I’m mandated by my investment technique to invest only in market leaders with proven market share data, and products that can be adopted by the largest companies, those that define and shape entire markets.
According to AuthenTec, the company has shipped over 100 million sensors to nine of the 10 largest PC OEMs. In addition, the company's sensors are being shipped in 20 million smartphones. The three top handset manufacturers: Samsung, Motorola Nokia and LG will go with AuthenTec for enterprise security.
So that’s my research strategy in a nutshell: what you want in your stock is a company with a better mousetrap, tsunami-like trends for products the company makes or services the company offers, the law of large numbers, validated market position and validated products by the industry’s movers and shakers.
The result is market-beating profits, which sometimes come fast, and sometimes come slow. Either way, the rewards from the independent research are gratifying.
Your guide to small-cap investing,
Editor of Cabot Small-Cap Confidential
P.S. Sign on to Cabot Small-Cap Confidential today before our deadline and I will not only waive our full-service fee of $1400 but also give you our Cabot family-only price of $950—so you'll save $450.
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